New Partnership Regulations Could Affect Your Exempt Organization
By: Denise Felber, CPA, Tax Partner, and Ashley Cooper, CPA, Tax Manager
In recent years, we have seen exempt organizations participating in more complex investments including alternative investments, publicly traded partnerships, and hedge funds. Exempt organizations participating in these investments may receive a Schedule K-1 from any fund that is organized as a partnership. With these new partnership regulations, it is imperative for organizations to review their investments to determine if they have any investments organized as partnerships and take the correct actions to protect themselves during these changes.
While most exempt organizations are not filing Form 1065s, they often receive the Schedule K-1 generated from that filling. Any entity that files a Form 1065 will be subject to these new regulations, which will require all the partnerships you are invested in to review and modify their partnership and limited liability agreement before January 1, 2018. The modification to the agreement results from the new income tax audit rules for partnerships.
Prior to 2018, a tax matters partner (“TMP”) was responsible for filing the partnership return. If the IRS generated an income adjustment for the partnership , the IRS would have to compute the income tax adjustment for each partner.
Effective with tax years beginning January 1, 2018, the TMP is no longer recognized in dealing with the IRS. With duties described in the new regulations, a partnership representative (“PR”) is the only person to deal with the IRS. The regulations do not require the IRS agents to contact or inform partners of audits or income changes. The PR doesn’t have to:
- be a partner,
- notify partners of an audit, or
- obtain partner input to agree to income adjustments.
The PR can also elect to have the new rules apply to years before 2018. Commentators and legal consultants suggest the selection process of and limitations on the actions of the representative be documented in the partnership or limited liability agreement.
If the IRS audit results in an increase in income or decrease in expenses, the partnership is responsible for the tax on the net income increase—at the highest tax rate. The tax payment (plus interest) by the partnership will pass through to the current partners as nondeductible deductions. Regardless of their ownership percentage in the year under audit, the capital account of current partners will be affected by the change.
The representative has options. If the partnership has 100 or fewer partners and none of them are partnerships or trusts , the PR can file an annual election with a timely filed return to elect out of the new partnership audit rules. If a Subchapter S Corporation is a partner, each shareholder is included in the partner count and a list of the shareholders’ names, addresses and identification numbers must be to be attached to the election. The status of grantor trusts and single member limited liability companies has not been addressed.
If the election does not apply or was not made, the partnership is liable for the tax. The PR can protest the tax calculation by substituting a computation with information regarding tax exempt partners. The PR also has the ability to “push out” the income adjustment to partners based on their ownership interests in the year under audit by issuing amended Schedule K-1s. The original partners could then amend their prior year returns to utilize losses and/or lower tax rates or pay the tax on their current year return. (Future tax returns will have a new line to add the tax from the audit to the current year tax liability.) The ability of a second-tier partnership to push out the income adjustment has not been addressed. If the former partners are not available or do not pay the tax, the partnership is still liable for the tax.
Reduction in net income resulting from the audit will be recognized in the current partnership return. A tax credit will not be generated.
The partnership or limited liability agreements should be adjusted to address:
- Access to details of partner, their tax status and their ownership if it is an entity .
- PR ability and/or responsibility to make the opt-out election .
- The allocation of tax payments to current owners for tax on prior returns.
- Indemnification agreements from withdrawing partners.
- The process to notify or poll current owners regarding:
- The IRS audit;
- The audit adjustments;
- The decision to push out the adjustment; and,
- The collection process from prior owners.
If your organization manages a partnership, contact an attorney familiar with these changes. Your agreement needs to be updated and your partners informed.
If your organization is a partner in an entity filing a Form 1065, you should receive a notice from the manager of your investment. Again, we can discuss the changes in the document with you.
And in the future if your organization plans to invest in an entity which will issue a Schedule K-1, you need to be aware of the potential liability you will be assuming for taxes for future and prior partners.
The regulations are very detailed and this article does not include all the changes. Our purpose is to provide our clients the relevant information which should be addressed this year. Your tax team at HoganTaylor is available to answer any questions or review documents.